Laminar Wealth Blog

As 2018 is quickly coming to a close, we’ve been busy wrapping up year-end planning. Last year’s last-minute passage of the Tax Cuts & Jobs Act (TCJA) sent us scrambling a year ago to take advantage of opportunities that were going away. This year-end has been a bit calmer when it comes to tax changes but has also forced us to approach things differently. We’ve had fun strategizing for our clients and were honored to lend a hand to several reporters looking to better understand and communicate the new opportunities. David has spoken with several journalists over the past few weeks and got quoted a handful of times:

Below are our expanded thoughts on one of the most popular topics we’ve discussed with clients this year:

Itemized Deductions & The Impact on Charitable Contributions

The changes to itemized deductions mean fewer taxpayers will itemize under the TCJA. State and local taxes (SALT) are limited to $10,000 and the only other notable deductions available for most are mortgage interest and charitable contributions. Between state income taxes and local property taxes, most of our clients are hitting the $10,000 SALT limit. Therefore, married couples filing jointly who also pay at least $14,000 in qualified mortgage interest will continue to itemize, since combined with SALT they will exceed the new $24,000 standard deduction for joint filers. For these taxpayers, charitable contributions still have the same impact of reducing your tax bill at your marginal rate that they have in the past.

Conversely, taxpayers without a mortgage may not receive a tax benefit on charitable contributions until they exceed $2,000 (if filing single/separately) or, if filing jointly, until giving exceeds $14,000! For many, this will be a disappointment, but not change their giving behavior, as taxes were never the primary motivator.

An interesting opportunity arises though for those with $10,000 of SALT and a significant mortgage, but where the annual interest is a bit shy of $14,000/yr. For example, a married couple with $10,000 of SALT, $13,000 of mortgage interest, and $1,000 of charitable contributions would not receive any tax benefit over simply taking the standard section of $24,000. However, each dollar they give to charity above that would reduce their taxes at their marginal tax rate. For example, if their marginal tax rate was 30% (Fed + state) they’d save $0.30 for each dollar they give. Therefore there’s an opportunity for them to “bunch” their charitable contributions. By giving $2,000 this year and $0 next year instead of $1,000 in each, they would save $300.

Using a donor-advised fund allows you to optimize this bunching strategy even further. Continuing with the example above, the married couple could contribute $6,000 to a donor-advised fund in year one, reduce their taxes by $1,500 and then distribute $1,000 per year from their donor-advised fund to their favorite charity every year for the next six years. This would accomplish their objectives of giving $1,000 per year, while also maximizing their tax deduction that would otherwise be worthless. This a great planning opportunity for those who are charitably inclined and able to front-land their gifts.

If you think the above situation applies to you but didn’t take advantage of it this year, don’t worry, the same opportunities will be available for 2019.

David recently had the opportunity to share his thoughts on the new tax law with Michelle Singletary of The Washington Post and was quoted in her article titled, "Start 2018 with a new strategy for your taxes." What follows is our expanded perspective on tax planning as we close out 2017 and prepare for 2018 and beyond.

The new tax law is bringing about significant changes in how we engage in strategic planning. Many opportunities are going away for good (e.g. recharacterization of Roth conversions) while some have popped up with only a brief window and need to be implemented before 12/31/17. In the past week and a half, there has been a lot of media attention on these strategies, and if you haven't already, you should consider doing the following right now.

Pay your Q4 estimated state income tax before 12/31/17 (if you will itemize for 2017 and will not be subject to AMT)

Prepay your property taxes to the extent currently assessed by your local jurisdiction (if you will itemize for 2017 and will not be subject to AMT)

Accelerate charitable gifts into 2017 (If you will itemize for 2017)

Thankfully, however, most of the changes in the tax law won't require you to make frantic moves. We are currently in the process of carefully reviewing the new legislation and discussing it with fellow tax professionals to make sure we understand the financial planning implications going forward. We will then contemplate each client's unique situation, evaluate the new opportunities created, and consider what changes should be made in our approach.

With so much current focus on taxes, it’s also important to step back and look at the big picture. While taxes can have a significant impact on financial decisions, the goal is not necessarily to minimize taxes, but rather to maximize after-tax return. Even more, tax planning, like all financial planning, should be done within the context of a broader life plan, so we not only seek to maximize wealth but also our return on life!

On September 27th, 2017, the President, along with House and Senate Republicans, released their framework for tax reform. The proposal aims to lower taxes, simply the federal tax code, and create a more competitive business environment. It’s important to note that the nine-page document provides only a broad outline, leaving many of the details to be determined by Congress when writing the potential bill. Here is what we’ve learned so far that we think could impact our clients:

Fewer Tax Brackets

Ordinary income is currently taxed at seven different tax brackets, ranging from 10% to 39.6%. Under the proposed framework, there would be only three—12%, 25%, and 35%. In addition, the framework allows for the possibility of a fourth tax rate that would apply to the highest-income taxpayers. It’s unclear whether this would be a fourth bracket like the current 39.6% rate or might instead resemble something like the Buffet Rule. While the details will have to be worked out by the tax-writing committees in Congress, the stated intention is for the tax system to maintain its progressive nature and not shift the burden from the wealthy to low- and middle-income households. Our initial thought is that while fewer tax brackets give the impression of simplicity, the number of tax brackets isn’t what makes our current tax code so onerous. In fact, having only three brackets means the transition between brackets would be less gradual, which would make hitting the next bracket potentially more painful! Until we know where the cut-offs for each bracket would be and what the potential “fourth-rate” looks like, it’s difficult to evaluate how this would impact specific taxpayers, so nothing to get to excited about yet.

Reduced Top Tax Rate for Small Business

Sole proprietors, partnerships, and S corporations would see business income taxed at a maximum rate of 25%. This is notably lower than the proposed 35% top tax bracket for normal wages, so the framework also discusses the need for measures to prevent wealthy taxpayers from inappropriately recharacterizing personal income into business income in order to take advantage of lower rates. This is potentially exciting news for small businesses, family-owned operations, and entrepreneurs; however until further details emerge regarding what would be classified as personal income versus business income (some have speculated that service professions could be excluded), it’s unclear whether all small business owners would benefit.

Doubling of the Standard Deduction

The standard deduction would roughly double to $24,000 for married couples and $12,000 for single individuals. This is good news for many low to mid-income taxpayers as it creates an effective 0% tax bracket on the first $24,000 of income for married couples. For many, if not most, this would more than offset the increase in the lowest bracket from 10% to 12%. It also means that many taxpayers who currently itemize deductions would instead use the new higher standard deduction, simplifying their tax preparation and record-keeping responsibilities.

Elimination of Most Itemized Deductions

Most itemized deductions would be eliminated, other than mortgage interest and charitable deductions. Therefore, unless one’s annual mortgage interest plus charitable gifts exceed $24,000, a married couple would be better off with the new higher standard deduction. This would mean more taxpayers would take the standard deduction, and therefore simplify the preparation and record-keeping. Perhaps the most significant deduction that would likely be eliminated is itemizing state and local taxes (e.g. state income tax and property taxes). This would most negatively impact those with high incomes living in states with high income taxes, such as California and New York, along with those who own expensive personal real estate.

Expanded Family Tax Credits

Personal exemptions for dependents would be replaced with an increased Child Tax Credit. The amount and details of the New Child Tax Credit were not specified, but would be higher than the current credit of $1,000 with higher income limits on the phaseout. In addition, there would be a new $500 credit for non-child dependents (e.g. aging parents).

While details were not provided, it likely means keeping the earned income tax credit (for low- to moderate-income workers), the American opportunity tax credit (for college expenses), and tax deductions for contributions to retirement plans (such as 401k plans and IRAs).

Repeal of the Alternative Minimum Tax (AMT)

The AMT is a supplemental income tax system that was initially designed to ensure high-income taxpayers weren't able to reduce their effective tax rate “too much” by taking advantage of all the deductions and incentives available under the standard tax system. Under the new proposal where most of these deductions would be eliminated, the AMT arguably becomes unnecessary. Given that the AMT is considered one of the most complex areas of the tax code, this would certainly simplify tax planning and preparation.

Elimination of the Estate and Generation-Skipping Taxes (but likely only for 10 years!)

We currently have an estate and gift tax exemption of $5.49 Million per individual. Estates larger than this are taxed at a rate of up to 40%. Under the proposed framework the estate and generation-skipping transfer tax would disappear. The gift tax (for transfers during one’s life) was not mentioned in the framework so it’s unclear whether it would remain intact or disappear also. However, assuming that the resulting tax bill is unable to receive 60 votes in the Senate and is passed through budget reconciliation instead (requiring only 51 vote, thus subject to the Byrd Rule), it’s likely to come back within 10 years. As a result, unless one is nearly certain they will die within that time frame, wealthy families should likely continue to plan as though there will be an estate tax.

How Should You Plan in the Interim?

Until the details are hammered out and we actually have a bill to review, it’s difficult to assess the impact the proposed changes would have on any specific taxpayer and thus what actions should be taken to minimize one’s tax liabilities. Until we have greater clarity, the almost timeless strategy of deferring income and accelerating deductions likely continues to make sense. For example, it's likely better to pay property taxes at the end of 2017 rather than the beginning of 2018, as they may not be an eligible deduction by then.

Special note for taxpayers who exercised Incentive Stock Options (ISO) - If you exercised ISOs in a prior year and paid AMT as a result, you likely have an AMT credit that you expected to get back when you eventually sell the shares. If the AMT is eliminated, as proposed in the released framework, it’s unclear how your AMT credit would be treated and there is a chance it could become worthless, significantly increasing your expected tax liability. Depending on the magnitude of this risk to your specific situation, you may want to consider selling enough shares before the end of 2017 to claim as much of the AMT credit as possible. Hopefully, we’ll get more clarity on this issue as we approach the end of the year, but we recommend looking at the scenario now so that you can move quickly toward the end of the year if necessary. If you still work for the company and are subject to black-out periods this is even more important as your opportunities to sell are already limited.

Now that tax season is over (unless you had to extend) you probably want to breathe a sigh of relief and forget about taxes again for another eight months or so. While that feeling is more than understandable, you may want to consider that it is also the perfect time to start exploring tax planning opportunities for the current year. If you take the time to engage in proactive and deliberate planning, your next tax season may not be so painful. Since most tax strategies have to be implemented before December 31st, the best way to minimize your taxes in the long-run is to think about it prior to filing. Last week, an article in USA Today examined this very concept, and featured several CPA financial planners, including yours truly.